Revenue-based financing is an alternative financing method tied to revenue streams. Particularly startups and growth companies make use of it. What is there to know about the revenue-focused financing method?
A non-dilutive way of financing based on company revenue streams? Revenue-based financing (RBF) offers that. It is also called revenue-based loan, revenue-based funding, or revenue share financing. Startups and business owners with recurring revenues use this kind of growth finance instrument.
Revenue-based financing is repaid based on a percentage of future sales, unlike traditional bank loans, which are paid back with interest. This debt financing instrument is especially interesting for growing businesses that have a high potential for future revenues.
Revenue-based funding is well known in the US and Great Britain. But Germany and Europe catch up. More and more early-stage companies from the software and SaaS industry utilize this alternative financing instrument. In 2023 the global revenue-based financing market is expected to grow to $3.38 billion.
This article explores revenue-based financing for startup funding, highlighting its inner workings and functions.
What is revenue-based financing?
Revenue-based financing is an alternative debt financing instrument with which early-stage and growth companies (Scale-ups) secure debt from investors.
This funding approach is non-dilutive, companies do not have to sell shares in exchange for raising equity capital. Instead, RBF provides an alternative or complementary option to equity financing. It adds another layer to a company's capital structure.
How does revenue-based financing work?
In an RBF arrangement, investors receive a fixed monthly percentage of a company's revenue in return for their investment. The repayment amount usually is capped, ranging from 1.5 to 3 times the initial investment.
No interest or repayment, but a share of the revenue
Since the repayment is associated with the revenue, the repayment horizon is flexible. It depends on the company's performance. Meaning: How fast does your monthly revenues grow?
The faster revenue increases, the quicker the agreed repayment amount is reached. However, this is not always advantageous.
The investor's logic behind revenue based financing is different from a traditional bank loan or venture debt. Business owners and investors are following the same goal: steady revenue growth. Both profit and suffer if revenue growth rises or declines.
However, it is important to note that the repayment period is not unlimited. Usually, there is a difference between short-term (less than 12 months) and long-term (up to 60 months) revenue-based funding.
Let’s illustrate that with a simple calculation.
Example for revenue-based financing
The conditions:
- A company generates monthly recurring revenue (MRR) of €500,000 at the beginning of the financing.
- Now, it is in touch with an RBF investor and wants to raise €500,000.
- The company agrees with the RBF investor on a monthly revenue share of 10%.
- The cap of the repayment amount is at a maximum of €1,000,000.
Due to the steady revenue growth, the company has repaid its financing to the investor after 12 months. Revenue growth is the only criterion that determines the margin of repayment. Why?
Investors thoroughly assess a company’s financials
With revenue based financing, there are no classic repayment or interest rates. It is based only on revenue growth.
Thus, for investors it is essential to conduct a data-based analysis of the company's financial metrics. Since the return on investment expected by investors is tied to future revenues, this assessment has to be in-depth and solid. Investors treat revenue and the customer base as assets that need to be valued. They focus on asset-light businesses within the tech and platform environment.
For the assessment, the investor analyzes different financial KPIs. The basis is revenue, customer base, cash flow, and bank data. These KPIs are pivotal in determining the investment decision, the amount of financing, and its percentage share of revenue.
Among those metrics are:
- Monthly and annual revenue growth (MRR/ARR)
- Customer Churn Rate
- Customer Concentration
- Net Dollar Retention (NDR)
These financial metrics allow investors a better analysis of companies with recurring revenues, which are likely from the SaaS or software industry. They can make better-informed predictions about the revenue development of those companies.
Therefore, startups considering revenue-based financing should have relevant and up-to-date data available before raising capital.
Who is eligible for revenue-based financing?
A financing method based on revenue is a good option for all companies with stable and growing future revenues, ideally in the form of recurring revenue, as it facilitates investor calculations.
On the other hand, RBF is perfect for companies with high gross margins. It allows them to better compensate for the monthly capital costs that come along with revenue based financing.
For constant revenues and high gross margins, a well-functioning product is crucial. Therefore, product-market fit is another essential factor.
Wanted: Product-market fit, recurring revenue, and high gross margins
Until startups have met these three conditions, debt financing – and thus RBF – rarely makes sense or is a good option.
These attributions apply to software companies whose business models rely on Software-as-a-Service or subscriptions. These companies are beyond their early stages. Besides SaaS, e-commerce companies with high gross margins are eligible for RBF, too.
Startups and early-stage companies using revenue-based funding
Due to these criteria, revenue focused financing has established itself in recent years primarily for two types of companies: startups and growth-focused companies from the tech sector.
However, this is not the only reason. For quite some time, tech startups had no access to debt financing. While traditional banks seek tangible assets like machines or real estate and favor profitability, this was something software and SaaS companies could not provide as security.
Tech startups focus on "soft" assets like customer base and revenue. Due to the lack of (data) expertise, this kind of business model is outside the risk profile of a bank or other traditional financial institutions. Moreover, companies in their growth phase do not solely focus on profitability.
Meanwhile, a bank's lending criteria do not consider this type of asset sufficient to raise debt. That's why classic debt financing instruments (traditional loans) are not easy accessible for startup funding.
Revenue financing is an alternative to traditional debt
For business owners and startups, the only way to get capital was to sell shares in exchange for equity – with all the negative consequences attached to it:
- In the event of an exit or IPO, investors receive part of the profits.
- Due to the dilution, new shareholders receive co-determination, voting, and control rights over the company. The founders lose influence on decisions and the direction of their own company.
- VC financing ties up the company's resources (due diligence) and the founder's time (negotiations). It incurs legal and consulting costs, and months can pass before money is in the bank account.
Revenue-based funding enables startups and scaleups to raise debt on an alternative path trough venture lending – without diluting shares and assigning new seats at the table.
The design of revenue-based financing
Period and usage: those criteria determine the design of RBF deals. Based on this, there is a distinction between short-term and long-term revenue financing.
Short-term revenue-based financing
- Period up to 12 months
- Financing amount up to €100,000 or 2-4 monthly revenues
- Refinance seasonal actions, events, hardware, or office equipment
- Investors are usually fintech, which provides a fully automated handling of all processes and can finance smaller funding sizes
Long-term revenue-based financing
- Period up to 60 months
- Financing amounts up to several million euros
- Refinance of all company’s expenses, such as operations, or large one-time expenses like M&A
- Investors are usually funds that are committed to long-term partnerships, including consulting, networking, and follow-up financing
What are the benefits of revenue-based financing?
Funding based on future revenues has the great advantage that startups can tap into a new source of capital that is not based on equity and thus doesn’t affect the dilution of shares.
More benefits of revenue based financing:
- Long-term RBF: A cash runway extension to postpone the next VC funding round to a more convenient time
- Build up liquidity and thus an improvement in cash balance
- Besides revenue no other securities, warrants, or personal guarantees are necessary
- Due to its non-dilutive nature, founders stay in control of their company
- A fast financing solution available in days
- A flexible financing solution because the repayment amount is tied to their performance. If the company doesn’t develop as expected, the amount of repayment adapts
- Lower cost of capital than venture capital or venture debt
What are the downsides of revenue-based financing?
However, revenue-based finance has not only advantages but also disadvantages. It is because not all companies and business models are eligible for it.
The downsides of revenue based financing include:
- To be attractive to revenue-based financing providers, companies must have consistent and recurring revenues and a high gross margin.
- Revenue-based financing firms must identify predictable growth, as they only invest in startups they expect to grow. Otherwise, an investment does not make sense to them.
- The faster a company grows, the sooner it reaches the repayment amount, and then the costs increase due to a rising Internal rate of return.
- With RBF, companies receive their funding all at once. However, they usually can't deploy their funds immediately. They remain in their bank account. This overfunding leads to a higher cost of capital and harms capital efficiency.
Recurring revenue financing and revenue-based financing
Another form of revenue financing is recurring revenue financing (RRF). It is also suitable for startups and early-stage companies focussing on growth.
With RRF, companies raise debt. The financing amount and interest rate are based on the level of recurring revenues. The use cases of RBF and RRF are overlapping, only the repayment terms differ.
RRF means fixed costs in advance
The difference: The costs of RRF are fixed at the beginning of a contract and remain throughout the entire period. They are not attached to revenue growth.
Debt is usually only allocated up to a financing limit, which depends on the annual recurring revenue of a company.
Revenue-based financing is for for early-stage companies
For companies with constant and recurring revenues, revenue-based financing is a good option and an ideal complement to a traditional loan (debt financing), venture capital (equity financing), or venture debt.
The company is dedicated to its performance and lets investors participate in future revenue growth but without giving up control over its company.
Both sides, investors and companies, pursue the same goal: steady revenue growth. It helps the investors, who get a faster return on their investment, and the company, which increases its value.
For startups, this flexibility means that capital costs adapt to their growth. If future revenues don't develop as expected, repayment and fixed interest rates do not become a permanent burden.
